Our financial independence assumptions – what about taxes?

Posted on September 9, 2016

Nothing can be said to be certain, except death and taxes.

Benjamin Franklin 1789.

When I wrote about our financial independence assumptions back in July, many readers asked if we were taking taxes into consideration. As the great Benjamin Franklin pointed out many years ago, taxes is definitely something that we must plan for in life. How much taxes do we need to pay on our divided income? Let’s take a closer look at our financial independence assumptions.

Disclaimer: I’m not a tax specialist. This post is simply my interpretation of the Canadian income tax system. Please consult a tax specialist regarding your income tax.

Since our core expenses do not include things like eating out, charity donations, entertainment, vacation, and education savings, we will add $950 per month to cover these non-core expenses.

This results in $3,220 per month in expenses, or $38,640 per year. For simple calculation, we will round this number up to $40,000.

So, to be financial independent, we need our dividend portfolio to produce $40,000 per year. While we do plan to continue some part time work when we are financial independent, dividend income will be the primary source of income.

Don’t you have to pay taxes on the $40,000 dividend income?

Yes but that’s the beauty of our dividend portfolio – we do not hold all of the dividend paying stocks in taxable accounts. We hold many of these stocks in tax advantage accounts like RRSP and TFSA.

RRSP (Registered Retirement Savings Plan) is a tax deferred account that is similar to the 401(k) in the US.

TFSA (Tax Free Savings Account) is a tax free account that is similar to the Roth IRA in the US. But there’s no age restriction on withdraws. We can withdraw money at anytime.

To make sure we are tax efficient, we hold all Canadian REITs and income trusts in TFSA. All US stocks and ADRs are held in RRSPs. We maximize our RRSP And TFSA before making any investments in taxable accounts.

Our Dividend Income Breakdown

Table below shows the dividend income breakdown of our dividend income in 2015 and so far in 2016.

How come over 45% of our dividend income comes from TFSAs?

Because our TFSA consist a number of high yield stocks like REITs and income trusts. We also hold Canadian dividend stocks in our TFSA. These Canadian dividend stocks tend to have higher yield rates compared to their US counterparts.

Due to RRSP withdrawal rules, it does not make sense to receive a large amount of dividend income from our RRSP (I’ll explain this later). So, we will need to start focusing on adding dividend stocks in TFSA and taxable accounts rather than RRSP. When we are financial independent, our ideal dividend income breakdown is 20% RRSP, 50% TFSA, and 30% taxable.

Taxes in Financial Independence – Scenario 1

What happens to income tax when we are financially independent and we are receiving $40,000 in dividend income per year? Using the 20% RRSP, 50% TFSA, and 30% taxable breakdown from above, our income breakdown would be:

RRSP: $8,000 (taxed)

TFSA: $20,000 (tax free!!!)

Taxable: $12,000 (taxed)

Note: We will assume the taxable dividend income is split 40-60 between Mrs. T and I.

There are tax consequences when withdrawing money from RRSP. Therefore, we need to come up with a withdrawal strategy. Our RRSP withdrawal strategy is to split the withdrawal amount between the two of us. Below are the RRSP withholding tax rates:

Since we are splitting our RRSP withdraws, we can withdraw $4,450 each and still receive $4,005 after paying 10% ($445) of withholding tax. The amount withdrawn is then considered as employment income.

When we file our income tax, our annual taxable income would look like below:

The two of us will pay $756 in taxes for a combined taxable income of $40,010. An average tax rate 1.89%! Because our marginal tax rates are so low, we would be getting part of the RRSP withholding taxes back . If the part time income is from our side businesses, we can most likely write off eligible expenses too, meaning we will be paying even less taxes.

Taxes in Financial Independence – Scenario 3

What if we make $40,000 in part time income plus $40,000 in dividend income?

In this $80,010 per year income scenario, we would be paying a total of $4,353 in federal and provincial taxes on a $60,010 taxable income. This is an average tax rate of 7.25%. To put into perspective, if Mrs. T and I were to make $32,005 and $48,005 in active income ($80,010 total), we would be paying a total of $12,001 in taxes, or about 15% average tax rate.

As a Canadian, I think it’s important to pay whatever amount taxes that we owe to make sure Canada stays great. Social services like health care, schools, public transportation rely on taxes. Therefore I have no problem paying a small amount on our taxable income.

Final Thoughts

The three scenarios above showed taxes on dividend income can be very minimum if we construct our dividend portfolio properly. It is indeed possible to rely on dividend income alone when we are financially independent. We need to maximize all of our TFSA contribution rooms to take advantage of the tax free dividend income. Since withdraws from RRSP are considered as employement income and taxed at our marginal tax rates, it is more efficient to receive dividend income from taxable accounts.

Moving forward, it is crucial that we construct our dividend portfolio and any working income so they are split roughly equally between the two of us.

Dear readers, what do you think about my assumptions? If you see any holes in my tax calculations and assumptions, I would very much love to hear from you.

Hi I’m Bob from Vancouver Canada, I am working toward joyful life and financial independence through frugal living, dividend investing, passive income generation, life balance, and self-improvement. This blog is my way to chronicle my journey and share my stories and thoughts along the way.
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First of all, its great to see the same thought process that we went though in our retirement budget and tax planning.

For the tax planning, this seems correct to me and mirrors what I found. Still to be determined are what surprises are in store for us with stocks that don’t issue “eligible dividends” like some REIT income. It seems hard to tell some times.

Our budget comes out to around 5k per month but it looks like we have more travel planned.

Our own retirement budget goes into more detail and is based on our own historical spending which we have tracked for 2 years or so. Some items you may want to think about:

– utilities seem low at $100 – does this include electricity, heat, sewage and water? – from our experience your auto maintenance and house maintenance seem low. We have $100 per month for both of these. – no pets, I assume? – travel insurance? When you are not covered through work anymore, this is an issue. – I would suggest breaking down your non-core expenses further. There’s a risk that you aren’t accounting enough there for travel, gifts, entertainment and other purchases. We do a detailed travel budget as well and average this over the year based on the estimated number and type of trip.

Thanks. I think the key is to keep ineligible dividends in either TFSA or RRSP and eligible dividends in taxable accounts. This way you can take advantage of the dividend tax credits.

Maybe my estimate is a bit on the conservative side. Our historical spending was outlined in the earlier post. We have been tracking our expenses for almost 5 years now and we’re spending about $50k per year. At $40k spending per year it might be a bit low but if we are traveling around in cheaper countries, I think these numbers are doable.

Utilities – yes include electricity, heat, sewage and water. We are averaging about $30 on hydro, $50 on natural gas, and about $10 on water & sewage per month right now. House & Auto – our house and car are relatively new so expect the maintenance cost to be low. Pet – We have a cat, that cost is in the buffer section Travel insurance – good point. I think either that can be covered in the buffer or the non-core expenses section.

Agree that we can probably freak down our non-core expenses. Again this is just a rough estimate. Since we include side business related expenses in non-core expenses and they kind of go up and down over time, it’s hard to do an accurate estimate.

Given this is just an estimate, I realized things can change over time. The post simply highlights the fact that it is indeed possible to live off dividend income and paying very little taxes. 🙂

Canadian tax system is very similar, there’s a threshold where qualified dividends are not taxed. The trick is to make sure our RRSP withdrawal amounts are smaller as they’re taxed as employment income.

skube

Ok so that I’m understanding correctly, basically a $1M portfolio with an expected 4% overall yield to produce $40k/yr.

The ideal is to have 50% of dividend income coming from high-yield stocks within the TFSA. The rest coming from taxable and RRSP accounts.

Isn’t there a large risk to high-yield anything? Isn’t it possible for companies to reduce dividends or suspend them completely in tough times? Isn’t it hard to achieve $20k yield from a TFSA account which only has a max contribution to date of $46.5k?

These numbers are assumptions when we reach financial independence, which is about 10 years or so away. So the TFSA account would have way higher than $46.5 contribution to date. Assuming $5,500 for 10 more years with no inflation indexed, that would be $101,500 max contribution limit. I think that amount will be much higher when taking inflation into consideration. Also the $20k/50% mix is in the ideal situation, whether we get to that mix or not we’ll have to see.

Yes there’s a larger risk to high-yield stocks… but REITs typically have a higher yield in the first place as they distribute 80-90% of their profits to shareholders. We don’t just buy REITs and income trusts in our TFSA, we also own other Canadian dividend stocks for diversification purposes.

skube

September 11, 2016 at 8:46 am

Ok so there’s a few assumptions although I can’t see inflation affecting TFSA that much over the next 10 years. I’ve read the TFSA contribution limit isn’t expected to increase or be indexed to inflation until 2019.

Assuming that remains unchanged and a generous average 3% inflation rate, would mean an increase of the max. cumulative contribution limit to around $120k by 2026 (not really that much larger than your initial number).

Of course, this doesn’t factor in any compound growth, which if we assume an average return of say 5.5% would result in around $160k*

So overall and rounding up, you would be extremely fortunate to have, say $200k in your TFSA in 10 years time yielding a consistent 10% to give you $20k/yr income.

Good points. Again as I mentioned before, these are just estimates. Who knows maybe our TFSA dividend income contribution is more like 40% when we are financial independent. Whether it’s 50% or 40% or something lower, what I’m showing in this post is that it’s indeed possible to live on dividend income and pay only a very small amount of income tax (if anyat all).

Given your calculation of $160k in 10 years. That’d be a total of $320k for the two of us. At $20k of dividend income per year, that’s roughly 6.25%. Given dividend growth in 10 years, I think that’s quite possible. 🙂

Mike Drak

September 9, 2016 at 1:19 pm

The tax problem that I now have to live with is that I have accumulated too much money in RRSP’s which is taxed as regular employment income when withdrawn. The whole premise of RRSP’s was that when you withdraw funds you would be in a lower tax bracket but in some cases you might find yourself in a higher tax bracket especially so if you continue to earn active income.t. So much for the Canadian tax system. They need to increase the TFSA limits further and give us a break.

That’s a problem we need to watch out for sure – having too much money in the RRSP. Definitely want to limit amount of money that we have to withdraw from RRSP to reduce amount of taxes that we need to pay.

I’m all for increasing the TFSA limits further. I was very sad that the Liberals government reduced the limits from $10k to $5.5k. At least the new limit is inflation indexed.

Taxes and healthcare expenses, since I live in the US, are the biggest question marks with financial independence. With government spending rising every year and I have less and less faith that the current tax system will stay in place. There’s likely to be changes namely higher taxes which could really screw things up for those in FI if they don’t have an adequate margin of safety. But it’s great to run through the numbers to play out different scenarios and have a plan in place beforehand.

I’m so glad that we live in Canada where healthcare is easier to estimate. We have to pay for healthcare but the cost is very low. Furthermore, if one makes less than a certain amount, then healthcare is free.

I think a tax professional told me that if we have 0 income the year before I withdraw from my 401k (at 59.5), then I pay zero income taxes on it. It’s hard for me to believe that which is why I’ll double check when the time comes but man taxes are so hard to understand but it’s something that everyone has to pay.

That’s great seeing you ran some estimation on your taxes. That will give you a good idea and be somewhat prepared. Taxes make me frustrated, seem to complicated. I just give it to my CPA lol, and have them figure all the numbers out. I should try to learn a bit more maybe later on.

jd

September 14, 2016 at 9:22 am

I did a similar exercise a while ago and got similar results for my situation. One thing you may want to consider is making a larger RSP withdrawal and contributing that to your TFSA. So in your situation #1, you could withdraw $10k from your RSP, spend $4500 and put $5500 into your TFSA. Your income would be low enough that there would be little to no net tax paid on this extra withdrawal, and you’d be reducing a potential future tax liability.

Also in your examples, your income tax is calculated on the amount withdrawn from the RSP before withholding tax, so the ’employment’ income should be $4450, but this won’t make much difference to your results.

Definitely. We probably will end up withdrawing RRSP to both fund our expenses and the annual TFSA contribution limits. That way we can continue increasing our TFSAs and the amount of dividend income coming from TFSA.

This is all provided that you stay in Canada, or at least that CRA still considers you as a resident of Canada. If you decide to move somewhere else you will probably be in a totally different (tax) situation.

Chrissy

February 15, 2017 at 10:36 pm

Great to see a fellow Vancouverite blogging about FI! It’s helpful to have more Canadian voices out there. I just have one question: how is it that you’ll be able to claim RRSP withdrawals as employment income? I find that fascinating as we’re also planning on early FI and trying to plan our withdrawal strategy. Thanks in advance for your time!

John R

In the above post & assumptions – are you currently renting, living with family, own your own property, are you mortgage free, or will you be mortgage free when you retire in your 40’s.

When you do retire sometime in your 40’s will you continue to contribute to RRSP’s (you need employment income to do this) as well as continue to pay into CPP (either self employed, working or within a business ownership)?

On RRSP withdrawals, if you do this in your 40’s, how long will the RRSP’s last before they’re melted down to zero?

Retiring in your 40’s will you be empty nesters, will you be paying for your childrens university education in part?

What do you see your lifestyle will be retiring in your 40’s, do you or will you have to work at anything for income or at that point will you have enough in ALL investments to keep your expenses covered?

We currently own our property. It’s not fully decided if we’ll stop working or not once we reach FI. We may stop working full time and do some part time work. We most likely won’t be contributing to RRSPs and have no plan to pay into CPP. We plan to pay for our kids’ university education but that depends if they decide to stay in Canada for university, or if they decide to go to Denmark (it’s free there). Our lifestyle will probably be similar as today. 🙂

My mission is to show that financial independence is indeed possible for a family with kids while living in an expensive city like Vancouver.

My focuses include dividend & ETF investing, financial independence, early retirement, happiness, fruguality, and finding the right personal balance between saving for the future and enjoying life today.